Nash Flash

9/29/2008

Investing and the business cycle: what can you do during recessions

Economic recessions at first glance usually spells doom for most people. Stocks plummet, purchases start to dwindle, people hold on to their money, and because of these, panic ensues and further chaos occurs which could lead to a full blown depression. According to some experts, considering the recent events, we are already in that stage, although some claim that the American economy was already in depression in the early part of this year.

To explain what they mean, there is an economic principle called the business cycle. The business cycle has four phases namely, peak, recession, through, and expansion. They occur one after the other, shifting in various lengths of time in a given number of years.

A peak is when the economy is all good. There are jobs everywhere, economic competition is healthy, gross domestic product is flourishing, and income levels are increasing. Although prices increase due to inflation, the economy is prosperous and most could ride the wave.

A recession is when everything is on decline. Jobs start to become scarce and financial growth begins to dwindle. Wages and prices of good are steady but this means negative growth in the economy.

A through is a low point. It is sometimes referred to as a depression. This is the period when economic output and employment crash.

A recovery, on the other hand, just means that the economy is on the rise. Everything experiences growth and the economic standing is good.

In essence, peak and through are the extremes of the business cycle. They are the highest and lowest points of economic strength. What investors should watch out for are recession and recovery periods because it means that the economy is in motion and they tell where the economy is headed in the immediate short-term.

Although they are cycles, the four do not go in sequential order. There are instances where a double dip recession occurs. This is when the economy falls, recovers for a while, then declines once again without hitting a peak.

A recession is loosely defined as two consecutive quarters of decline in GDP output. In the United States, the National Bureau of Economic Research (NBER) is an organization that determines what the economic state of the country is. NBER quantifies the economic standing based on four factors: employment, personal income, sales volume in manufacturing and retail sectors, and industrial production. Based on these indicators, experts at NBER gauge the status of the market and determine whether the economy is on the rise or in recession.

However, these four are inconsistent or inaccurate at times. There are instances where the indicators are lagging, which means that the indicators change only after the fact. This just means that a lagging indicator can verify the state of the economy at the present, but it would not be beneficial to predict the near future.

Although it is a simple concept, understanding the business cycle could help an investor plan out his activities for the next few weeks or months. During a recession, there are some things one could do.

Contrary to popular belief, a falling market does not mean one could not make money in that period. Some take advantage by short selling stocks. This is when an investor sells short profits when a stock declines in value. Nevertheless, pulling this off has a high degree of difficulty and entails a lot of risk and should only be done by more experienced investors.

Another type of investor is a value investor. This involves mass buying cheap stocks so that he could sell it once the economy improves.

A third type of investor is the steady investor. He thinks more of the long term and continues dollar-cost averaging even in a bad market. However, this entails a lot of patience and is recommended more for those saving for their retirement.

As for you, it is up to you where you fall among the three. Knowing who you are determines what plan of action you could do in times of recession.

In conclusion, a recession is more than doom and gloom if you know the business cycle and that it is just a normal occurance in the market. What you do during this time is up to you.